I am a layman in economics. I am curious about the current devaluation of Australian Dollar in comparison with the US Dollar. Could someone please explain, in simplest words possible:

What causes currency devaluation? Is it a variety of factors or are there some common factors in all currency devaluations?

What does this devaluation mean for people living in Australia, people living in US, and people living in other countries, say China? I understand that one of the consequences for Australians is that their exports become cheaper, so foreign countries have more incentive to buy Australia products. For Australians, this could potentially mean more incentive to produce/work/innovate, and to decrease their imports. In other (naive) words, tighten their belts, rely more on themselves and less on the external world. This, logically, seems like a positive sign and should have good consequences. Does this interpretation have any element of truth in it? And is there another, completely opposite, possible outcome of this devaluation?

What are good (smart) ways for the Australian government and policy makers to respond to this?

How does devaluation translate in "standard of living". I was looking at the historical exchange rate of AUD and USD here since 2000. Interestingly, in March 2001, the AUD was almost half of USD, and in July 2011, it was more than 1 USD! Surely, it does not mean that the standard of living in Australia in March 2001 was twice as bad as it was in July 2011 (in comparison with US), does it?

I understand that forex rates involve an interconnection of many factors. But, I want to be educated about how much we know about it, and how much of what we know is actually useful for us.

1 Answer
1

This question is heavily reliant on the context of when it was asked. A lot has happened since February with respect to the Australian Dollar.

A currency devaluation can be caused by quite a few factors. In the case of Australia, the devaluation is occurring with respect to the USD. The AUD remains strong but the US is currently experiencing a surge in consumer confidence. There is also a few larger factors at play. The USD is seen as basically the safest investment one can make. In recent history, govt bonds have been less attractive. As a result, Australian Sovereign bonds have been more attractive as they are very safe. In short, the AUD devaluation has more to do with the strength of the US than any domestic weakness (although Australian economic performance has been underwhelming).

Another key factor relates to the resources boom in Australia. This has primarily been driven by an increase in demand from China instead of an increase in mineral output. The resources book has been a key driver of economic growth. In March/April, the iron ore price took a big hit, partly due to weakening demand from China. As a result of the change in price, the value of Australia's exports dropped very quickly. This directly reduces our Terms of Trade. Manufacturers are pretty happy about this and it is expected they will pick up some of the slack from the stagnating mining sector.

This devaluation has a few flow through consequences. Exporting to the US is cheaper. Importing from the US in particular is more expensive. A good way to think about it is if you are Australian and are thinking about travelling to the US for a holiday, you would be pretty upset. Your trip just got a lot more expensive very quickly. If you own a hotel and you cater to a lot of American tourists, you will be very happy. It will be cheaper for them to come. This change is good for our exporters, including natural resources, manufacturers and services.

The RBA typically responds to these issues very well. Their main instrument of monetary policy is the interest rate.

There isn't much need for a monetary policy response to the devaluation of the dollar. The RBA targets inflation rate which is preferred to Exchange Rate Targeting by many governments.

With respect to a fiscal policy response, The IMF has a working paper on Fiscal Policy and the Real Exchange rate. It doesn't answer it perfectly, but it is definitely worth a read. The key point is that the effect depends critically on (i) the composition of public spending, (ii) the underlying financing policy, (iii) the intensity of private
capital in production, and (iv) the relative productivity of public infrastructure

There should be very low immediate pressure on the standard of living. It gets more expensive to import into Australia, but Australian produced products are more competitive in the international marketplace.

$\begingroup$I will flesh out the answer a bit more and provide references when I can. Probably in the evening.$\endgroup$
– JamzyFeb 4 '15 at 0:25

$\begingroup$Adding to this great answer: the housing market in several cities, particularly Sydney and Byron Bay, have suffered with higher property demand (as the price of property, in USD, lowers).$\endgroup$
– JoaoBotelhoOct 3 '17 at 8:51